Megan McArdle posed the titular question, observing that:
Rajat Gupta, formerly a director at Proctor and Gamble and Goldman Sachs, has been indicted on multiple counts of passing insider information about the companies he was supposed to be helping to oversee. He is alleged to have delivered this information to Raj Rajaratnam, the hedge-fund manager who just got 11 years for insider trading.
Ho-hum! Yawn. More corruption on Wall Street, right?
Not quite. This is a very interesting case, because Gupta is not accused of having directly profited from the tips. He's accused merely of having used them to build his relationship with Rajaratnam.
Why is this interesting?
Well, for starters, because insider trading cases usually require proving that the insider who delivered the information did so for some gain. That gain doesn't have to be immediate, or in cash, but it does have to be something that you can point to and say "That's what he got out of it".
"Rajaratnam's goodwill" is slightly more nebulous than I believe usually goes to trial. And that's not just because you have to spend hours in court arguing about whether this is actually valuable. It's also because without a gain, there's less in the way of a paper trail. ...
I'm no lawyer, but I suspect that this case will ultimately prove a stiff uphill slog. Nebulous securities cases don't seem to do well in front of juries; either the jury gets mad at the prosecutor for boring them, or they err on the side of the defendant because the whole thing was too hard to understand. (This is what a securities litigator told me, anyway.) Much-lionized "tough on Wall Street" prosecutors like Spitzer and Giuliani tended to lose any case they took to trial.
I am a lawyer. Moreover, I wrote the book on the topic (okay, a book on the topic) in Securities Law: Insider Trading. And I don't think this aspect of the case against Gupta will prove much of a problem for the government.
To be sure, McArdle's not the only observer who thinks that this aspect of the Gupta case is problematic. University of Chicago law professor Randal Picker has written that:
According to Wayne State University Law School professor Peter J. Henning in a recent New York Times article, there are complications to each aspect of this case. ...
Proving Gupta received a personal benefit from his alleged tips to Rajaratnam is likely the hardest aspect of the case for the Department of Justice. In Dirks vs. SEC, the Supreme Court said that to prove insider trading by a tipper, “the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders.” The indictment itself is surprisingly muted on this aspect, merely stating that Gupta “provided the inside information to Rajaratnam because of Gupta’s friendship and business relationships with Rajaratnam. Gupta benefitted and hoped to benefit from his friendship and business relationships with Rajaratnam in various ways, some of which were financial”. Gupta’s lawyer, in contrast, stated that during the time in question his client lost his entire investment in the Galleon Fund. It will be interesting to see what evidence prosecutors have to demonstrate how exactly Gupta benefitted (especially since the financial relationships between Gupta and Rajaratnam cited in the indictment occurred mostly from 2003 through 2006, well before 2008).
But did he write the book on the topic? Nope. I did. And I've got another one in the works. So trust me. The personal benefit part of the case is not going to be a problem.
In the first place, it's important to understand that Gupta is not charged with insider trading as such. Instead, he is charged with the related offense of tipping information to an outsider who then used it to trade.
The framework for tipping liability was established by the US Supreme Court in a case called Dirks v. SEC, 463 U.S. 646 (1983). As I explain in Securities Law: Insider Trading:
Raymond Dirks was a securities analyst who uncovered the massive Equity Funding of America fraud. Dirks first began investigating Equity Funding after receiving allegations from Ronald Secrist, a former officer of Equity Funding, that the corporation was engaged in widespread fraudulent corporate practices. Dirks passed the results of his investigation to the SEC and the Wall Street Journal, but also discussed his findings with various clients. A number of those clients sold their holdings of Equity Funding securities before any public disclosure of the fraud, thereby avoiding substantial losses. After the fraud was made public and Equity Funding went into receivership, the SEC began an investigation of Dirk's role in exposing the fraud. One might think Dirks deserved a medal (one suspects Mr. Dirks definitely felt that way), but one would be wrong. The SEC censured Dirks for violating the federal insider trading prohibition by repeating the allegations of fraud to his clients.
Dirks appealed all the way to the Supreme Court.
... the court held that a tippee's liability is derivative of that of the tipper, "arising from [the tippee's] role as a participant after the fact in the insider's breach of a fiduciary duty." A tippee therefore can be held liable only when the tipper breached a fiduciary duty by disclosing information to the tippee, and the tippee knows or has reason to know of the breach of duty.
On the Dirks facts, this formulation precluded imposition of liability. To be sure, Secrist was an employee and, hence, a fiduciary of Equity Funding. But the mere fact that an insider tips nonpublic information is not enough under Dirks. What Dirks effectively proscribes is not merely a breach of confidentiality by the insider, but rather the breach of a fiduciary duty of loyalty to refrain from profiting on information entrusted to the tipper. Looking at objective criteria, courts must determine whether the insider-tipper personally benefited, directly or indirectly, from his disclosure. Secrist tipped off Dirks in order to bring Equity Funding's misconduct to light, not for any personal gain. Absent the requisite personal benefit, liability could not be imposed.
... Note that, at least in theory, it is possible for a tipper to be liable even if the tippee is not liable. The breach of duty is enough to render the tipper liable, but the tippee must know of the breach in order to be held liable.
Gupta is the tipper. He therefore can be held liable if the government shows that he (a) disclosed material nonpublic information to Rajaratnam (b) in return for a personal benefit (c) expecting Rajaratnam to trade. The question raised by mcArdle goes to the second prong; namely, whether Gupta's making tips "to build his relationship with Rajaratnam" rises to the requisite personal benefit. I think the answer to that question is easy and affirmative.
Dirks itself held that the tipper can be held liable when he "“receive[s] a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.” 463 US at 663. The court further explained that "The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient." Id. at 664. As the Second Circuit later explained, by this formulation "the Supreme Court has made plain that to prove a § 10(b) violation, the SEC need not show that the tipper expected or received a specific or tangible benefit in exchange for the tip." SEC v. Warde, 151 F.3d 42, 48 (2d Cir. 1998). In that case, the court held that "The close friendship between [tipper] Downe and [tippee] Warde suggests that Downe's tip was 'inten[ded] to benefit' Warde, and therefore allows a jury finding that Downe's tip breached a duty under § 10(b)." Id. at 49. If a "close friendship" is not too nebulous, getting on the good side of a major player in the hedge fund industry is a very easy case.
The Gupta case thus can be instructively contrasted with SEC v. Maxwell, 341 F. Supp. 2d 941 (S.D. Ohio 2004), which rejected tipper liability on grounds that the alleged tipper was unlikely to receive any future pecuniary or reputational benefit from giving tips to his barber. Rajaratnam was no barber!
I therefore readily endorse the analysis of the issue offered up by Thomson Reuters Accelus' Staff:
In S.E.C. v. Sekhri, the court both distinguished and refined the concept of personal benefit as an element of insider trading:
The first part of Sehgal's argument fails because it is based on an overly narrow interpretation of the rule stated in Dirks. While Sehgal is correct in arguing that the evidence must show that Sekhri sought some personal benefit from disclosing the nonpublic information to Sehgal in order to have breached his fiduciary duty, he ignores the remainder of the Court's statement.… While noting that the insider must seek to benefit from disclosing inside information, the Supreme Court noted that “[t]here are objective facts and circumstances that often justify [the] inference” that the insider benefitted from the disclosure…. For example, “[t]he elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend.” …. (emphasis added (by Court)). Thus, when Sekhri disclosed insider information to his father-in-law, Sehgal, it may be inferred that Sekhri received some personal benefit from the gift of information. Likewise, the burden of proof shifts from the SEC to Sehgal, and Sehgal must prove that his son-in-law derived no benefit from the disclosure in order to negate the inference that Sekhri benefitted from the transaction.
In the case of Gupta and Rajaratnam, the two men, in addition to years-long friendship, had a number of investments together.
The SEC therefore will get precisely the same inference and resulting shift in the burden of proof in the Gupta case that it got in Sekhri. That's particularly significant, because it means the jury instructions likely will spell out rather precisely the path for the jury to find the requisite personal benefit.
In sum, aspects of the Gupta case may pose proof problems for the government, but the personal benefit requirement is unlikely to be the source of those problems.